06 August 2007

I'm a nonreligious person. Not that this matters much in the context of personal finance, but it does reveal a little about my personality, my desires, and the things I allow to drive my way of thinking.

Specifically, I loathe dogma. Not the movie Dogma, which is actually pretty funny, but dogma in general. "Because it is" or "because it always has been" or "because that's how it's supposed to be" are not valid reasons for doing anything. Period. Make each decision with an eye on history and common thought, but with the bulk of your decision coming from an informed logical thought process.

I began to think about this when I saw a question about a car purchase asked on a popular investing message board:

I'm going to buy a new Honda within a couple of weeks. I have the total money for the car sitting in a Vanguard money market. I can get 2.9% financing for 3 years or 4.9% financing for 5 years. Is there any reason why I shouldn't do the 3-year 2.9% financing. My after tax return from the money market account (about 3.5%) is greater than what money markets are returning. In addition, it's nice to have that extra money liquid for a few years.

The basic question: if a loan makes me come out ahead, should I use the loan offer or pay cash?

I was not the least bit surprised to see two suggestions in response, each stated and seconded at least once by the board regulars (paraphrased):

Your mistake is buying a new car. You'll do better financially if you buy a 1- or 2-year old car.

It's always better to pay cash when you have the option.

Now, does this advice strike you as sound, logical advice? Maybe it does, because both ideas have been crammed down our throats in the personal finance community. But in fact these responses come so readily because they are dogmatic. They are true because they are true.

The truth in the matter is that #1 is usually true but not always, and #2 is false even more frequently.

First let's talk about #1, because I have purchased a new Honda in recent years, and also because, well, I labeled it #1. Some vehicles hold their value far, far better than others, to the point where the first-year depreciation is not very dramatic. Specifically I'm talking about Hondas and Toyotas here, which have proven over time to be reliable vehicles that are inexpensive to maintain. Their residual value is so good, in fact, that shopping for used Hondas and Toyotas can be very, very frustrating. We feel, as consumers, that in addition to a year's wear and tear, we ought to get a price break on a used car because, well, it's not brand new. And in fact, we are completely right when we're talking about most cars. But these days, there is very little premium to be had when buying a used Honda or Toyota. If it's a "certified used" vehicle, in fact, sometimes the used car is more expensive than a new one because there's an extended warranty built in. This has happened over time due to market pressures, to the point that many shoppers have concluded that buying new may be the more sound decision. I know my new Pilot, which I bought under invoice, was cheaper than any used Pilot I had found with under 30,000 miles. So while it is good advice to pay attention to used cars and what they may offer financially, to say that you are always doing better by buying used is not a statement based in logic or fact, but instead is one based on dogma.

Response #2 is fraught with even more problems because there is a clear, quantitative message that the loan is a better financial decision. A simple read will tell you that the original poster's cash works harder for him in his money market fund than it would if he sunk it into the vehicle. Not only that, but using the cheap loan allows him to keep more cash on hand for the life of the loan, effectively extending his emergency fund and giving him a more liquid overall financial picture. For the life of the loan, he will have the option to pay it off if that becomes the more sound choice based on prevailing money market rates. But he will also have the option of maintaining the payments for as long as he finds it to be to his advantage. Refusing the loan and paying cash closes off this second option unnecessarily, and will make him more cash-poor in the short term and less wealthy in the long term. So why, why, why, do so many people seem to say "buy with cash regardless?" DOGMA! another infuriating example of a failure to think because one thinks the answer lies within their tried and true dogma.

I could give a hundred more examples of misleading dogma in the personal finance area alone, and the problem infests our entire way of being in all other areas as well. Challenge conventional wisdom, peer pressure, and your own beliefs. Only by doing this will you truly make the smartest decisions in your life. Reliance on dogma can lead to poor decision making and, more importantly, a more feeble mind due to inactivity.

17 comments:

I see it this way. You only get a rate that low with a new car purchase, so when you figure in the added depreciation loss, you actually aren't making more money by keeping the cash in a money market (or other investment) than if you had bought used with cash, saved thousands on the initial purchase AND a lower depreciation rate over a 3-5 year period.

Some vehicles depreciate more than others, but the rate of depreciation is higher on a new car vs used (near as I can tell).

All I know is that trade-in value on my Pilot 1 year later was only $2k less than I paid for it. So I know that the depreciation on my Pilot has been small enough that I probably could not have done any better with a used model. This is far from universally true, but then again that is the point I was making.

Definitely not universally true. The Kelley Blue Book average cost for a new 2007 Honda Pilot is $26,582. The trade-in value for an identical 2006 Pilot in excellent condition with 23,000 miles (normal for that age) is 21,300. That a $5000+ depreciation in one year.

If you resold to a private party, you'll do better than on the trade-in, with the private party resale value coming in at $23,260.

A 2005 Pilot purchased from a private party will run you $20,655, or about $6000 less than new.

Basically, you either got a REALLY good deal on your trade-in (which can happen) or the dealer off-set the extra value he gave you on the trade with the money from a hidden incentive that they chose not to disclose or pass on (which happens quite often).

Of course, as with ANY purchase (and many PF bloggers become judgemental and lose sight of this fact) the "market value" of something may not be the same as the value to you.

A good example is my Tommy Bahama shoes that I wear at work. I think they cost me about $80 or $100 a few years back. I could buy equivalent shoes (both styling and wear) in a no-name for $50.

However, when I'm in a meeting from hell, I benefit from those Tommy Bahamas invoke images of tropical shores for me. I can think about sand, surf, and pina coladas while someone drones on and on.

Would I say Tommy Bahama shoes are a good value? Well, if they soothe you like they do me, yeah! If not, no.

New cars are the same way. The difference in cost between new and used pushes me to go used. However, the pleasure of a new vehicle ordered EXACTLY the way you want has value as well. The value of that is completely dependent on your personal values and likes.

I agree . . . by no means was the deal I got normal. But I also think residual value has dropped a little for SUVs these days due to gas mileage. My Pilot would get about $18,500 trade-in now, but a year after I bought it the average on KBB/NADA/Edmund's was $22,500. I paid $24,500 for it. This was late in the model year and the dealer did have factory incentives, so I could not have gotten that deal 6 months earlier.

Anyway, the whole point is that you shouldn't assume that the common mantra is alwasy true . . . do your research. My car is just an example of one case where the traditional wisdom was not true.